c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Cost Behavior and Cost-Volume-Profit Analysis Chapter 19

Learning Objectives 1. Classify costs as variable costs, fixed costs, or mixed costs. 2. Compute the contribution margin, the contribution margin ratio, and the unit contribution margin. 3. Determine the break-even point and sales necessary to achieve a target profit. 4. Using a cost-volume-profit chart and a profit-volume chart, determine the break-even point and sales necessary to achieve a target profit. 5. Compute the break-even point for a company selling more than one product, the operating leverage, and the margin of safety.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Classify costs as variable costs, fixed costs, or mixed costs. 1

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Cost Behavior o Cost behavior is the manner in which a cost changes as a related activity changes. Understanding the behavior of a cost depends on:  Identifying the activities that cause the cost to change, called activity bases (or activity drivers).  Specifying the range of activity over which the changes in the cost are of interest. This range of activity is called the relevant range.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Variable Costs o Variable costs are costs that vary in proportion to changes in the level of activity.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Variable Costs o Jason Sound Inc. produces stereo systems. The parts for the stereo systems are purchased from suppliers for $10 per unit (a variable cost) and are assembled by Jason Sound Inc. For Model JS-12, the direct materials costs for the relevant range of 5,000 to 30,000 units of production are shown on the next slide.

V ARIABLE C OSTS

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Variable Costs o As shown in the previous slides, the variable costs have the following characteristics:  Cost per unit remains the same regardless of changes in the activity base.  Total cost changes in proportion to changes in the activity base.

Total Direct Materials Cost $300,000 $250,000 $200,000 $150,000 $100,000 $50, $20 $15 $10 $ Number of Units of Model JS-12 Produced Units Produced (000) Direct Materials Cost per Unit Total Direct Materials Cost 5,000 units$10$ 50,000 10,00010l00,000 15, ,000 20, ,000 25, ,000 30, ,000 Cost per Unit V ARIABLE C OSTS

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Fixed Costs o Fixed costs are costs that remain the same in total dollar amount as the activity base changes.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Fixed Costs o Minton Inc. manufactures, bottles, and distributes perfume. The production supervisor is Jane Sovissi. She is paid $75,000 per year. The plant produces from 50,000 to 300,000 bottles of perfume.

The more units produced, the lower the fixed cost per unit. F IXED C OSTS

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Fixed Costs o Fixed costs have the following characteristics:  Cost per unit changes inversely to changes in the activity base.  Total cost remains the same regardless of changes in the activity base.

Total Salary $150,000 $125,000 $100,000 $75,000 $50,000 $25, Units Produced (000) Number of Bottles of Perfume Produced Salary per Unit $1.50 $1.25 $1.00 $.75 $.50 $ Units Produced (000) Total Salary for Jane Sovissi 50,000 bottles$75,000$ ,00075, ,00075, ,00075, Salary per Bottle of Perfume Produced F IXED C OSTS

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Mixed Costs o Mixed costs have characteristics of both a variable and a fixed cost. Mixed costs are sometimes called semivariable or semifixed costs. o Over one range of activity, the total mixed cost may remain the same. Over another range of activity, the mixed cost may change in proportion to changes in the level of activity.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Mixed Costs o Simpson Inc. manufactures sails, using rented equipment. The rental charges are $15,000 per year, plus $1 for each machine hour used over 10,000 hours.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Mixed Costs o The rental charges for various hours used within the relevant range of 8,000 hours to 40,000 hours are as follows:

M IXED C OSTS

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Mixed Costs o The high-low method is a cost estimation method that may be used to separate mixed costs into their fixed and variable components.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Mixed Costs o The Equipment Maintenance Department of Kason Inc. incurred the following costs during the past five months:

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Mixed Costs o The number of units produced is the activity base, and the relevant range is the units produced between June and October. The next four slides illustrate how the high-low method is used to determine the fixed and variable costs.

First, select the highest and lowest levels of activity. ProductionTotal (Units) Cost June1,000$45,550 July1,50052,000 August2,10061,500 September1,80057,500 October75041,250 Actual costs incurred Variable Cost per Unit = Difference in Total Cost Difference in Production M IXED C OSTS

ProductionTotal (Units) Cost June1,000$45,550 July1,50052,000 August2,10061,500 September1,80057,500 October75041,250 Next, fill in the formula for difference in total cost. $61,500 41,250 $20,250 Variable Cost per Unit = Difference in Total Cost Difference in Production $20,250 M IXED C OSTS

2, ,350 Then, fill in the formula for difference in production. ProductionTotal (Units) Cost June1,000$45,550 July1,50052,000 August2,10061,500 September1,80057,500 October75041,250 Variable Cost per Unit = Difference in Total cost Difference in Production $20,250 1,350 M IXED C OSTS

Variable cost per unit is $15 ProductionTotal (Units) Cost June1,000$45,550 July1,50052,000 August2,10061,500 September1,80057,500 October75041,250 $15 = $15 Variable Cost per Unit = $20,250 1,350 M IXED C OSTS

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Fixed Cost = Total Costs – (Variable Cost per Unit x Units Produced) Mixed Costs o The fixed cost is estimated by subtracting the total variable costs from the total costs for the units produced as shown below:

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Fixed Cost = $61,500 – ($15 x 2,100 units) Fixed Cost = $61,500 – $31,500 $30,000 Fixed Cost = $30,000 Highest Level Fixed Cost = Total Costs – (Variable Cost per Unit x Units Produced) Mixed Costs o The fixed cost is the same at the highest and the lowest levels of production as shown below for Kason Inc.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Lowest Level Fixed Cost = $41,250 – ($15 x 750 units) Fixed Cost = $41,250 – $11,250 $30,000 Fixed Cost = $30,000 Fixed Cost = Total Costs – (Variable Cost per Unit x Units Produced) Mixed Costs o The fixed cost is the same at the highest and the lowest levels of production as shown below for Kason Inc.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Total Cost = ($15 x 2,000) + $30,000 Total Cost = $30,000 + $30,000 $60,000 Total Cost = $60,000 Total Cost = ($15 x Units Produced) + $30,000 Mixed Costs o With fixed costs and variable costs estimated at $30,000 plus $15 per unit, a formula is in place to estimate production at any level. If the company is expected to produce 2,000 units in November, the estimated total cost would be calculated as follows:

Total Variable Costs Total Units Produced Unit Variable Costs Total Units Produced Per-Unit Cost Total variable costs increase and decrease proportionately with activity level. Per-unit variable costs remain the same regardless of activity level. Total Costs Summary of Cost Behavior Concepts

Total Units Produced Total Costs Total Units Produced Total fixed costs remain the same regardless of activity level. Per-unit fixed costs decrease as activity level increases. Total Fixed Costs Unit Fixed Costs Per-Unit Cost Summary of Cost Behavior Concepts

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Summary of Cost Behavior Concepts o Some examples of variable, fixed, and mixed costs for the activity base units produced are as follows:

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Summary of Cost Behavior Concepts o One method of reporting variable and fixed costs is called variable costing or direct costing. o Under variable costing, only the variable manufacturing costs are included in the product cost. o The fixed factory overhead is treated as an expense of the period in which it is incurred.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Compute the contribution margin, the contribution margin ratio, and the unit contribution margin. 2

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Cost-Volume-Profit Relationships o Cost-volume-profit analysis is the examination of the relationships among selling prices, sales and production volume, costs, expenses, and profits.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Cost-Volume-Profit Relationships o Some of the ways cost-volume-profit analysis may be used include the following:  Analyzing the effects of changes in selling prices on profits  Analyzing the effects of changes in costs on profits  Analyzing the effects of changes in volume on profits  Setting selling prices  Selecting the mix of products to sell  Choosing among marketing strategies

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Contribution Margin o Contribution margin is the excess of sales over variable costs, as shown in the formula below. Contribution Margin = Sales – Variable Costs

C ONTRIBUTION M ARGIN Assume the following data for Lambert, Inc.:

C ONTRIBUTION M ARGIN

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Contribution Margin Ratio o The contribution margin ratio, sometimes called the profit-volume ratio, indicates the percentage of each sales dollar available to cover fixed costs and to provide income from operations. It is computed as follows: Contribution Margin Ratio = Contribution Margin Sales

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Contribution Margin Ratio = Contribution Margin Sales Contribution Margin Ratio = $400,000 $1,000,000 40% Contribution Margin Ratio = 40% Contribution Margin Ratio o The contribution margin ratio is 40% for Lambert Inc., computed as follows:

100% 60% Contribution Margin Ratio =40% Sales – Variable Costs Sales $1,000,000 – $600,000 $1,000,000 Contribution Margin Ratio = 40% 30% 10% Contribution Margin Ratio

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Change in Income from Operations Change in Sales Dollars x Contribution Margin Ratio = Change in Income from Operations $32,000 $80,000 x 40% = $32,000 = Contribution Margin Ratio o If Lambert Inc. adds $80,000 in sales from the sale of an additional 4,000 units, its income will increase by $32,000, as computed below.

Proof C ONTRIBUTION M ARGIN R ATIO

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Unit Contribution Margin o The unit contribution margin is useful for analyzing the profit potential of proposed decisions. The unit contribution margin is computed as follows: Unit Contribution Margin = Sales Price per Unit Variable Cost per Unit –

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Unit Contribution Margin o The unit contribution margin is most useful when the increase or decrease in sales volume is measured in sales units (quantities). o The change in income from operations can be determined using the following formula: Change in Income from Operations Change in Sales Units = x Unit Contribution Margin

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Change in Income from Operations Change in Sales Units = x Unit Contribution Margin Change in Income from Operations = $120,000 15,000 units x $8 = $120,000 Unit Contribution Margin o Lambert Inc.’s sales could be increased by 15,000 units, from 50,000 to 65,000 units. Lambert’s income from operations would increase by $120,000 (15,000 x $8), as shown below.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Unit Contribution Margin o Lambert Inc.’s contribution margin income statement, shown below, confirms that income increased to $220,000 when 65,000 units are sold.

R EVIEW 100% 60% 40% 30% 10% $20 12 $ 8 Sales (50,000 units)$1,000,000 Variable costs 600,000 Contribution margin$ 400,000 Fixed costs 300,000 Income from operations$ 100,000 Unit contribution margin analyses can provide useful information for managers.

Total contribution margin in dollars. Contribution margin ratio (percentage). The contribution margin can be expressed in three ways: Unit contribution margin (dollars per unit). 100% 60% 40% 30% 10% $20 12 $ 8 Sales (50,000 units)$1,000,000 Variable costs 600,000 Contribution margin$ 400,000 Fixed costs 300,000 Income from operations$ 100,000 R EVIEW

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Determine the break-even point and sales necessary to achieve a target profit. 3

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Break-Even Point o The break-even point is the level of operations at which a company’s revenues and expenses are equal.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Break-Even Point o Assume the following data for Baker Corporation: Fixed costs$90,000 Unit selling price$25 Unit variable cost 15 Unit contribution margin$10

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Break-Even Sales (units) = Fixed Costs Unit Contribution Margin Break-Even Sales (units) = $90,000 $10 9,000 units Break-Even Sales (units) = 9,000 units Break-Even Point o The break-even point (in sales units) is calculated using the following equation:

Income from operations is zero when 9,000 units are sold—hence, the break-even point is 9,000 units. B REAK -E VEN P OINT

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Break-Even Sales (dollars) = Fixed Costs Contribution Margin Ratio $225,000 Break-Even Sales (dollars) = $225,000 $90, Break-Even Sales (dollars) = $10 $25 Break-Even Point o The break-even point (in sales dollars) is calculated using the following equation:

Effect of Changes in Fixed Costs

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Effect of Changes in Fixed Costs o Bishop Co. is evaluating a proposal to budget an additional $100,000 for advertising. The data for Bishop Co. are as follows:

Break-Even Sales (units) = Fixed Costs Unit Contribution Margin Without additional advertising: Break-Even Sales (units) = $600,000 $20 = 30,000 units With additional advertising: Break-Even Sales (units) = $700,000 $20 = 35,000 units Effect of Changes in Fixed Costs

Effect of Changes in Unit Variable Costs

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Effect of Changes in Unit Variable Costs o Park Co. is evaluating a proposal to pay an additional 2% commission on sales to its salespeople (a variable cost) as an incentive to increase sales. Fixed costs are estimated at $840,000. The other data for Park Co. are as follows:

$250 – [$145 + ($250 x 2%)] = $100 Without additional 2% commission: Break-Even Sales (units) = $840,000 $105 = 8,000 units Break-Even Sales (units) = Fixed Costs Unit Contribution Margin With additional 2% commission: Break-Even Sales (units) = $840,000 $100 = 8,400 units Effect of Changes in Unit Variable Costs

Effect of Changes in Unit Selling Price

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Effect of Changes in Unit Selling Price o Graham Co. is evaluating a proposal to increase the unit selling price of a product from $50 to $60. The estimated fixed costs are $600,000. The following additional data have been gathered:

Break-Even Sales (units) = Fixed Costs Unit Contribution Margin Without price increase: Break-Even Sales (units) = $600,000 $20 = 30,000 units With price increase: Break-Even Sales (units) = $600,000 $30 = 20,000 units Effect of Changes in Unit Selling Price

Summary of Effects of Changes on B/E Point

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Target Profit o The sales volume required to earn a target profit is determined by modifying the break- even equation. Sales (units) = Fixed Costs + Target Profit Unit Contribution Margin

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. What would be the necessary sales to earn the target profit of $100,000? Target Profit o Assume the following data for Waltham Co.:

Sales (units) = Fixed Costs + Target Profit Unit Contribution Margin 10,000 units Sales (units) = 10,000 units Sales (units) = $200,000 + $100,000 $30 T ARGET P ROFIT

Proof ) T ARGET P ROFIT

Contribution Margin Ratio = Unit Contribution Margin Unit Selling Price Contribution Margin Ratio = $30 $75 From an earlier slide Contribution Margin Ratio = 40% Sales (dollars) = Fixed Costs + Target Profit Contribution Margin Ratio Sales (dollars) = $200,000 + $100,000 40% $750,000 = $750,000 Necessary sales to earn a $100,000 target profit T ARGET P ROFIT

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Using a cost-volume-profit chart and a profit-volume chart, determine the break-even point and sales necessary to achieve a target profit. 4

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Cost-Volume-Profit (Break-Even) Chart o A cost-volume-profit chart, sometimes called a break-even chart, graphically shows sales, costs, and the related profit or loss for various levels of units sold.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Cost-Volume-Profit (Break-Even) Chart o The cost-volume-profit charts in this section are based on Exhibit 5, which was constructed using the following data: (continued )

Sales and Costs (in thousands) 0 Units of Sales (in thousands) $500 $450 $400 $350 $300 $250 $200 $150 $100 $ 50 Dollar amounts are indicated along the vertical axis Volume is shown along the horizontal axis. C OST -V OLUME - P ROFIT (B REAK - E VEN ) C HART

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Cost-Volume-Profit (Break-Even) Chart o Using maximum sales of $500,000 and knowing that each unit sells for $50, we can find the values on the two axes. Where the horizontal sales and costs line intersects the vertical 10,000 units of sales line is Point A in the next slide. (continued )

Point A Sales and Costs (in thousands) 0 $500 $450 $400 $350 $300 $250 $200 $150 $100 $ 50 Units of Sales (in thousands) Point A could have been plotted at any sales level, because linearity is assumed. C OST -V OLUME - P ROFIT (B REAK - E VEN ) C HART

Beginning at zero on the left corner of the graph, connect a straight line to the dot (Point A). This is the total revenue or total sales line. Point A Sales and Costs (in thousands) 0 $500 $450 $400 $350 $300 $250 $200 $150 $100 $ 50 Units of Sales (in thousands) Total Revenue C OST -V OLUME - P ROFIT (B REAK - E VEN ) C HART

Sales and Costs (in thousands) 0 $500 $450 $400 $350 $300 $250 $200 $150 $100 $ 50 Units of Sales (in thousands) Fixed cost of $100,000 is a horizontal line. Fixed Cost C OST -V OLUME - P ROFIT (B REAK - E VEN ) C HART

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. (continued ) Cost-Volume-Profit (Break-Even) Chart o A point on the chart is needed to establish the cost line. An arbitrary sales amount is picked of 10,000 units. At this sales level, the cost should be $400,000, calculated as follows: [(10,000 x $30) + $100,000] = $400,000.

Sales and Costs (in thousands) 0 $500 $450 $400 $350 $300 $250 $200 $150 $100 $ 50 Units of Sales (in thousands) A point is marked at $400,000, where 10,000 units are sold. (continued ) C OST -V OLUME - P ROFIT (B REAK - E VEN ) C HART

Sales and Costs (in thousands) 0 $500 $450 $400 $350 $300 $250 $200 $150 $100 $ 50 Units of Sales (in thousands) A line is drawn from fixed costs at zero sales ($100,000) to this point. This is the total costs line. (continued ) Total Costs C OST -V OLUME - P ROFIT (B REAK - E VEN ) C HART

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Cost-Volume-Profit (Break-Even) Chart o The line would be the same if another point had been picked. For example, assume that 8,000 units had been chosen. At this sales level, the cost should be $340,000 [(8,000 x $30) + $100,000]. (continued )

Sales and Costs (in thousands) 0 $500 $450 $400 $350 $300 $250 $200 $150 $100 $ 50 Units of Sales (in thousands) The 8,000 units line drawn vertically intersects the total costs line at $340,000. $340,000 C OST -V OLUME - P ROFIT (B REAK - E VEN ) C HART

Sales and Costs (in thousands) 0 $500 $450 $400 $350 $300 $250 $200 $150 $100 $ 50 Units of Sales (in thousands) The point where the revenue (blue) line and the total costs (orange) line intersect is the break-even point. Break-even Point (continued ) C OST -V OLUME - P ROFIT (B REAK - E VEN ) C HART

Sales and Costs (in thousands) 0 $500 $450 $400 $350 $300 $250 $200 $150 $100 $ 50 Units of Sales (in thousands) Break-even is sales of 5,000 units or $250,000. Break-even Point C OST -V OLUME - P ROFIT (B REAK - E VEN ) C HART

Sales and Costs (in thousands) 0 $500 $450 $400 $350 $300 $250 $200 $150 $100 $ 50 Units of Sales (in thousands) Break-even Point Operating Loss Area Operating Profit Area C OST -V OLUME - P ROFIT (B REAK - E VEN ) C HART

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Cost-Volume-Profit (Break-Even) Chart o A proposal to reduce fixed costs by $20,000 is to be evaluated. The cost-volume-profit chart in Exhibit 6 (next slide) was designed to assist in this evaluation. Note that the total costs line has been drawn from fixed costs at zero sales of $80,000, reducing the break-even point to dollar sales of $200,000, or 4,000 units.

C OST -V OLUME - P ROFIT (B REAK - E VEN ) C HART

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Profit-Volume Chart o Another graphic approach to cost-volume- profit analysis, the profit-volume chart, plots only the difference between total sales and total costs (or profits). Again, data from Exhibit 5 are used. Unit selling price$ 50 Unit variable cost 30 Unit contribution margin$ 20 Total fixed costs $100,000 Unit selling price$ 50 Unit variable cost 30 Unit contribution margin$ 20 Total fixed costs $100,000

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Profit-Volume Chart o The maximum operating loss is equal to the fixed costs of $100,000. Assuming that the maximum unit sales within the relevant range is 10,000 units, the maximum operating profit is $100,000, as shown below. Maximum profit

P ROFIT -V OLUME C HART

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Sales (10,000 units x $50)$500,000 Variable costs (10,000 units x $30) 300,000 Contribution margin (10,000 units x $20)$200,000 Fixed costs 120,000 Operating profit$ 80,000 Sales (10,000 units x $50)$500,000 Variable costs (10,000 units x $30) 300,000 Contribution margin (10,000 units x $20)$200,000 Fixed costs 120,000 Operating profit$ 80,000 Revised Maximum profit Profit-Volume Chart o Assume that an increase in fixed costs of $20,000 is to be evaluated. The maximum operating profit would be $80,000, as shown below:

P ROFIT -V OLUME C HART

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Assumptions of Cost-Volume-Profit Analysis o The primary assumptions are as follows:  Total sales and total costs can be represented by straight lines.  Within the relevant range of operating activity, the efficiency of operations does not change.  Costs can be divided into fixed and variable components.  The sales mix is constant.  There is no change in the inventory quantities during the period.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Compute the break-even point for a company selling more than one product, the operating leverage, and the margin of safety. 5

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Sales Mix Considerations o Many companies sell more than one product at different selling prices. In addition, the products normally have different unit contribution margins. o The sales mix is the relative distribution of sales among the various products sold by a company.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Sales Mix Considerations o Cascade Company sold Products A and B during the past year as follows:

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Sales Mix Considerations o It is useful to think of the individual products as components of one overall enterprise product. For Cascade Company, the overall enterprise product is called E. The unit selling price, unit variable cost, and unit contribution margin for E are computed as follows:

Break-Even Sales (units) = Fixed Costs Unit Contribution Margin Break-Even Sales (units) = $200,000 $25 8,000 units Break-Even Sales (units) = 8,000 units Sales Mix Considerations

S ALES M IX C ONSIDERATIONS Break-even point

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Operating Leverage o The relationship of a company’s contribution margin to income from operations is measured by operating leverage. A company’s operating leverage is computed as follows: Operating Leverage = Contribution Margin Income from Operations

Both companies have the same contribution margin. O PERATING L EVERAGE

Contribution Margin Income from Operations Jones Inc.: Jones Inc.: $100,000 $20,000 = 5= 5 5 O PERATING L EVERAGE

Contribution Margin Income from Operations Wilson Inc.: $100,000 $50,000 = 2= O PERATING L EVERAGE

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Operating Leverage o Operating leverage can be used to measure the impact of changes in sales on income from operations. This measure can be computed as follows: Percent Change in Income from Operations = Percent Change in Sales Operating Leverage x

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Percent Change in Income from Operations = Jones Inc.: 50% 10% x 5 = 50% Percent Change in Income from Operations = Wilson Inc.: 20% 10% x 2 = 20% Operating Leverage o Assume that sales increased 10%, or $40,000 ($400,000 x 10%), for Jones Inc. and Wilson Inc.

50% increase ($10,000/$20,000) O PERATING L EVERAGE

20% increase ($10,000/$50,000) O PERATING L EVERAGE

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Operating Leverage o The impact of a change in sales on income from operations for companies with high and low operating leverage can be summarized as follows:

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Margin of Safety o The margin of safety indicates the possible decrease in sales that may occur before an operating loss results. o The margin of safety may be expressed in the following ways:  Dollars of sales  Units of sales  Percent of current sales

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Margin of Safety = Sales – Sales at Break-Even Point Sales 20% Margin of Safety = 20% Margin of Safety = $250,000 – $200,000 $250,000 Margin of Safety o If sales are $250,000, the unit selling price is $25, and the sales at the break-even point are $200,000, the margin of safety is 20%, computed as follows:

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Appendix Variable Costing

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Variable Costing o The cost of manufactured products consists of direct materials, direct labor, and factory overhead. The reporting of all these costs in financial statements is called absorption costing. o Absorption costing is required by GAAP.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Variable Costing o In variable costing, also called direct costing, the cost of goods manufactured consists of direct materials, direct labor, and variable factory overhead. o In a variable costing income statement, fixed factory overhead costs do not become a part of the cost of goods manufactured.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Variable Costing o Instead, fixed factory overhead costs are treated as a period expense.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Variable Costing o The form of a variable costing income statement is as follows:

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Variable Costing o Assume that 15,000 units are manufactured and sold at a price of $50. The related costs and expenses are as follows:

V ARIABLE C OSTING

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Cost Behavior and Cost-Volume-Profit Analysis The End